- Yahoo is undervalued based on a sum of the parts analysis.
- Yahoo should be trading at $48.63 to $71.58.
- The core business should exhibit significant improvements as improving margins paired with acquisitions should sufficiently drive both top and bottom line growth.
Yahoo (NASDAQ:YHOO) should be worth significantly more (this is after breaking down and updating the intrinsic value of Yahoo subsidiaries and the core business). However, there hasn’t been a whole lot of institutional interest in the company, and many investors haven’t really found the long-term growth potential of the ad-business that appealing.
Despite these two shortcomings, I have high conviction that Yahoo will outperform. Furthermore, I’m highly confident that Alibaba will trade at a much higher value following the IPO, which will also drive the stock price of Yahoo higher.
Yahoo Investment thesis
I think that if investors are patient and are willing to wait for the display ad business to stabilize following the transition to mobile devices, investors may be surprised by the significant upside from just the core business alone.
Let’s now take a quick look at historical financial performance of Yahoo. In Yahoo’s fiscal year 2012, the company generated $3.31 EPS, which was mostly driven by selling a portion of its Alibaba holdings. The company recognized a $4.6 billion gain from those assets, inflating the FY 2012 figure to that extent. However, when excluding the impact from the sale of its assets, using a 31% income tax rate, the company generated $1.066 billion in net income. On an EPS basis that translates into $.89 EPS.
Analysts on a consensus basis anticipate Yahoo to generate $1.42 EPS in fiscal year 2014. In fiscal year 2013 Yahoo reported $1.30 EPS. So over a three year period the EPS figure has improved at a 17.12% CAGR. Remember, this is after excluding the impact from recognizing the sale of Alibaba in FY 2012 and FY 2014.
Yahoo: A Sum of the parts (SOTP) valuation
Yahoo sold its Alibaba shares at around $68, generating $8.3 billion on a pre-tax basis. When factoring in taxes, Yahoo will have $5.4 billion left over, which will give the company the ability to buy back shares and pursue a couple of acquisitions. However, following the Alibaba IPO, Yahoo’s remaining 401.8 million shares in Alibaba are worth $37.72 billion, based on Friday’s $93.89 closing price. The remaining stake in Alibaba, after factoring in a 35% tax rate, is worth $24.5 billion. In total (after factoring taxes), Alibaba contributes $30 billion to Yahoo’s net intrinsic value.
Yahoo’s 35% equity interest in Yahoo Japan ($23.5 billion market capitalization) is worth $8.225 billion. After factoring in the impact from a 35% capital gains tax, the equity interest in Yahoo Japan is worth $5.34 billion.
Yahoo’s equity (total assets – total liabilities) is $13 billion. Adding that to the Alibaba and Yahoo Japan stake value and Yahoo has $48.34 billion worth in intrinsic value. I add back owner equity because the equity interest in Alibaba and Yahoo! Japan are not recognized at mark-to-market.
So assuming net income is $1.4 billion in fiscal year 2014, at 25.61 times earnings, Yahoo the core business should be worth $35.84 billion. When factoring the inclusion of Alibaba and Yahoo Japan, Yahoo should be worth $71.18 billion.
Currently, Yahoo has a $40.7 billion market cap, which makes it heavily undervalued on a purely tangible basis. I think the stock should trade closer to $48.63. However in a more optimistic case scenario, the stock should trade at $71.58. I think the core business is too heavily undervalued, and while the fundamentals of the business may take a while to improve, there are many cost levers that Yahoo can implement to improve margins. Furthermore, the company has plenty of cash to drive sales growth through various acquisitions.
In very rare instances a stock will trade well below its intrinsic value, and in this case, Yahoo serves as perhaps one of the most extreme examples in recent history.
I think value investors will like this investment opportunity as it’s based more on tangible value rather than speculation over future growth prospects. While the long-term growth trajectory isn’t as appealing, the underlying value of Yahoo’s holdings is worth significantly more than Yahoo’s market value. Therefore, I think it’s a great investment opportunity with significant upside over the immediate short-term.